Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the quarterly period ended June 30, 2011.

or

o

Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the transition period from to .

Commission File Number

QKL STORES INC.

(Exact name of registrant as specified in its charter)

Delaware

75-2180652

(State or Other Jurisdiction of

Incorporation or Organization)

(I.R.S. Employer

Identification No.)

4 Nanreyuan Street

Dongfeng Road

Sartu District

Daqing, P.R. China 163311

(Address of Principal Executive Offices including zip code)

011-86-459-4607987

(Registrant’s Telephone Number, Including Area Code)

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes xNo o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every, Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes xNo o

Indicate by check mark if the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company

Large Accelerated Filer o

Accelerated Filer o

Non-Accelerated Filer o

(Do not check if a smaller reporting company)

Smaller reporting company x

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Securities Exchange Act).

Yes o No x

The Registrant had 31,344,590 shares of common stock outstanding on August 12, 2011.

Common stock, $0.001 par value per share, authorized 100,000,000 shares, issued and outstanding 30,269,590 and 29,743,811 shares at June 30, 2011 and December 31, 2010, respectively

30,270

29,744

Series A convertible preferred stock, par value $0.01, authorized 10,000,000 shares, issued and outstanding 6,769,549 and 7,295,328 at June 30,2011 and December 31, 2010, respectively

67,695

72,953

Additional paid-in capital

91,147,667

90,710,619

Retained earnings – appropriated

6,012,675

6,012,675

Retained earnings

4,649,112

2,094,850

Accumulated other comprehensive income

9,556,577

7,194,141

Total shareholders’ equity

111,463,996

106,114,982

Total liabilities and shareholders’ equity

$

186,071,382

$

169,618,717

See notes to unaudited condensed consolidated financial statements.

2

QKL STORES INC. AND SUBSIDIARIES

Condensed Consolidated Statements of Income

(Unaudited)

(Unaudited)

Three Months

Ended June 30,

Six Months

Ended June 30,

2011

2010

2011

2010

Net sales

$

83,453,372

$

66,099,594

$

184,764,468

$

147,705,707

Cost of sales

68,828,405

54,504,918

152,044,021

121,584,917

Gross profit

14,624,967

11,594,676

32,720,447

26,120,790

Operating expenses:

Selling expenses

12,749,493

7,117,955

25,286,696

13,983,993

General and administrative expenses

1,946,466

1,731,613

4,150,083

3,898,871

Total operating expenses

14,695,959

8,849,568

29,436,779

17,882,864

Income from operations

(70,992

)

2,745,108

3,283,668

8,237,926

Non-operating income (expense):

(Increase) decrease in fair value of warrants

-

-

-

7,801,649

Interest income

163,762

195,810

453,385

344,928

Interest expense

-

(8,201

)

(31,100

)

(10,381

)

Total non-operating income (loss)

163,762

187,609

422,285

8,136,196

Income (loss) before income taxes

92,770

2,932,717

3,705,953

16,374,122

Income taxes

125,637

820,348

1,151,691

2,378,902

Net income (loss)

$

(32,867

)

$

2,112,369

$

2,554,262

$

13,995,220

Comprehensive income statement:

Net income (loss)

$

(32,867

)

$

2,112,369

$

2,554,262

$

13,995,220

Foreign currency translation adjustment

1,784,806

173,612

2,362,436

45,485

Comprehensive income

$

1,751,939

$

2,285,981

$

4,916,698

$

14,040,705

Weighted average number of shares outstanding:

Basic

29,755,085

29,667,924

29,771,783

29,613,671

Diluted

29,755,085

39,859,213

37,039,139

40,332,126

Earnings per share:

Basic

$

(0.001

)

$

0.07

$

0.09

$

0.47

Diluted

$

(0.001

)

$

0.05

$

0.07

$

0.35

See notes to unaudited condensed consolidated financial statements.

3

QKL STORES INC. AND SUBSIDIARIES

Condensed Consolidated Statements of Cash Flows

(Unaudited)

Six Months

Ended June 30,

2011

2010

CASH FLOWS FROM OPERATING ACTIVITIES:

Net income

$

2,554,262

$

13,995,220

Depreciation – property, plant and equipment

3,566,227

2,309,342

Amortization

15,249

13,662

Share-based compensation

432,316

591,814

Deferred income tax

(169,473

)

(256,827

)

Change in fair value of warrants

-

(7,801,649

)

Adjustments to reconcile net income to net cash provided by operating activities:

Accounts receivable

(610,942

)

33,031

Inventories

7,934,102

5,706,734

Other receivables

11,580,644

(37,080

)

Prepaid expenses

(5,164

)

(272,240

)

Advances to suppliers

(598,759

)

401,054

Accounts payable

(3,597,550

)

(6,394,315

)

Cash card and coupon liabilities

1,194,685

(169,382

)

Customer deposits received

(310,921

)

(3,172,881

)

Accrued expenses and other payables

5,272,840

187,656

Income taxes payable

(1,284,241

)

152,112

Net cash provided by operating activities

25,973,275

5,286,251

CASH FLOWS FROM INVESTING ACTIVITIES:

Purchases of property, plant and equipment

(7,775,089

)

(2,831,895

)

Refund of office building purchase payment

-

11,015,480

Decrease of restricted cash

41,960

55,765

Net cash provided by (used in) investing activities

(7,733,129

)

8,239,350

Effect of foreign currency translation

332,622

(13,352

)

Net increase in cash

18,572,768

13,512,249

Cash – beginning of period

17,460,034

45,912,798

Cash – end of period

$

36,032,802

$

59,425,047

Supplemental disclosures of cash flow information:

Interest received

$

220,968

$

344,928

Interest paid

$

31,100

$

10,381

Income taxes paid

$

2,562,939

$

2,495,550

See notes to unaudited condensed consolidated financial statements.

4

QKL STORES INC. AND SUBSIDIARIES

Notes to Unaudited Condensed Consolidated Financial Statements

NOTE 1 – ORGANIZATION AND BUSINESS OPERATIONS

QKL Stores Inc. (“Store”) was incorporated under the laws of the State of Delaware on December 2, 1986. Store currently operates through a wholly owned subsidiary in the British Virgin Islands: Speedy Brilliant Group Ltd. (“Speedy Brilliant (BVI)”), wholly owned subsidiary of Speedy Brilliant (BVI) located in Mainland China: Speedy Brilliant (Daqing) Ltd. (“Speedy Brilliant (Daqing)” or “WFOE”), operating company located in Mainland China: Daqing Qingkelong Chain Commerce & Trade Co., Ltd. (“Qingkelong Chain”), which Store controls, through contractual arrangements between WFOE and Qingkelong Chain, as if Qingkelong Chain were a wholly owned subsidiary of Store, and wholly owned operating subsidiary of Qingkelong Chain located in Mainland China: Daqing Qinglongxin Commerce & Trade Co., Ltd (“Qinglongxin Commerce”).

The Store and its subsidiaries (hereinafter, collectively referred to as the “Company”) are engaged in the operation of retail chain stores in the PRC.

The Company is a regional supermarket chain that currently operates 32 supermarkets, 15 hypermarkets and 4 department stores in northeastern China and Inner Mongolia. The Company’s supermarkets and hypermarkets sell a broad selection of merchandise including groceries, fresh food and non-food items. A supermarket offers various daily necessities on a self-service basis and averages 2,500 square meters in sales area. A hypermarket is similar to a supermarket but has a larger operating scale, and is typically over 4,500 square meters in sales area. The Company currently has two distribution centers servicing its supermarkets.

The Company is the first supermarket chain in northeastern China and Inner Mongolia that is a licensee of the Independent Grocers Alliance, or IGA, a United States-based global grocery network. As a licensee of IGA, the Company is able to engage in group bargaining with suppliers and have access to more than 2,000 private IGA brands, including many that are exclusive IGA brands.

Principles of Consolidation and Presentation

The condensed consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles (“U.S. GAAP”). The condensed consolidated financial statements include the financial statements of QKL Stores Inc., and its wholly owned subsidiaries. All intercompany accounts, transactions, and profits have been eliminated upon consolidation.

The accompanying interim unaudited condensed consolidated financial statements (“Interim Financial Statements”) of the Company and its wholly owned subsidiaries have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information and are presented in accordance with the requirements of Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, these Interim Financial Statements do not include all of the information and notes required by GAAP for complete financial statements. These Interim Financial Statements should be read in conjunction with the consolidated financial statements and notes thereto for the fiscal year ended December 31, 2010 included in the Company’s Form 10-K. In the opinion of management, the Interim Financial Statements included herein contain all adjustments, including normal recurring adjustments, considered necessary to present fairly the Company’s financial position, the results of operations and cash flows for the periods presented. The operating results and cash flows of the interim periods presented herein are not necessarily indicative of the results to be expected for any other interim period or the full year.

5

QKL STORES INC. AND SUBSIDIARIES

Notes to Unaudited Condensed Consolidated Financial Statements

NOTE 2 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could materially differ from those estimates.

Segment Reporting

The Company operates in one industry segment, operating retail chain stores. ASC 280, Segment Reporting, establishes standards for reporting information about operating segments. Given the economic characteristics of the similar nature of the products sold, the type of customer and the method of distribution, the Company operates as one reportable segment as defined by ASC 280, Segment Reporting.

Revenue Recognition

The Company earns revenue by selling merchandise primarily through its retail stores. Revenue is recognized when merchandise is purchased by and delivered to the customer and is shown net of estimated returns during the relevant period. The allowance for sales returns is estimated based upon historical experience.

Cash received from the sale of cash cards (aka “gift cards”) is recorded as a liability, and revenue is recognized upon the redemption of the cash card or when it is determined that the likelihood of redemption is remote (“cash card breakage”) and no liability to relevant jurisdictions exists. The Company determines the cash card breakage rate based upon historical redemption patterns and recognizes cash card breakage on a straight-line basis over the estimated cash card redemption period. The Company recognized approximately nil in cash card breakage revenue for the six months ended June 30, 2011 and 2010.

6

The Company records sales tax collected from its customers on a net basis, and therefore excludes it from revenue as defined in ASC 605, Revenue Recognition.

Included in revenue are sales of returned merchandise to vendors specializing in the resale of defective or used products, which accounted for less than 0.5% of net sales in each of the periods reported.

Cost of Sales

Cost of sales includes the cost of merchandise, related cost of packaging and shipping cost, and the distribution center costs.

Selling Expenses

Selling expenses include store-related expense, other than store occupancy costs, as well as advertising, depreciation and amortization, utilities, labour costs, preliminary expenses and certain expenses associated with operating the Company’s corporate headquarters.

Advertising Costs

Advertising costs are expensed as incurred. Advertising expense, net of reimbursement from suppliers, amounted to $102,977 and $90,402 for the six months ended June 30, 2011 and 2010, and amounted to $39,753 and $52,897 for the three months ended June 30, 2011 and 2010, respectively. Advertising expense is included in selling expenses in the accompanying condensed consolidated statements of income. The Company receives co-operative advertising allowances from vendors in order to subsidize qualifying advertising and similar promotional expenditures made relating to vendors’ products. These advertising allowances are recognized as a reduction to selling expenses when the Company incurs the advertising cost eligible for the credit. Co-operative advertising allowances recognized as a reduction to selling expenses amounted to nil for the six months ended June 30, 2011 and 2010.

Vendor Allowances

The Company receives allowances for co-operative advertising and volume purchase rebates earned through programs with certain vendors. The Company records a receivable for these allowances which are earned but not yet received when it is determined the amounts are probable and reasonably estimable, in accordance with ASC 605. Amounts relating to the purchase of merchandise are treated as a reduction of inventory cost and reduce cost of goods sold as the merchandise is sold. Amounts that represent a reimbursement of costs incurred, such as advertising, are recorded as a reduction in selling and administrative expense. The Company performs detailed analyses to determine the appropriate amount of vendor allowances to be applied as a reduction of merchandise cost and selling expenses.

Inventories

Inventories primarily consist of merchandise inventories and are stated at lower of cost or market and net realizable value. Cost of inventories is calculated on the weighted average basis which approximates cost.

Management regularly reviews inventories and records valuation reserves for damaged and defective returns, inventories with slow-moving or obsolescence exposure and inventories with carrying value that exceeds market value. Because of its product mix, the Company has not historically experienced significant occurrences of obsolescence.

7

Inventory shrinkage is accrued as a percentage of revenues based on historical inventory shrinkage trends. The Company performs physical inventory count of its stores once per quarter and cycle counts inventories at its distribution centers once per quarter throughout the year. The reserve for inventory shrinkage represents an estimate for inventory shrinkage for each store since the last physical inventory date through the reporting date.

These reserves are estimates, which could vary significantly, either favorably or unfavorably, from actual results if future economic conditions, consumer demand and competitive environments differ from expectations.

Income Taxes

The Company follows ASC 740, Income Taxes, which requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the financial statements or tax returns. Under this method, deferred income taxes are recognized for the tax consequences in future years of differences between the tax bases of assets and liabilities and their financial reporting amounts at each period end based on enacted tax laws and statutory tax rates, applicable to the periods in which the differences are expected to affect taxable income. Valuation allowances are established, when necessary, to reduce deferred tax assets to the amount expected to be realized.

The Company adopted ASC 740-10-25 on January 1, 2007, which provides criteria for the recognition, measurement, presentation and disclosure of uncertain tax position. The Company must recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such a position are measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate resolution. The Company did not recognize any additional liabilities for uncertain tax positions as a result of the implementation of ASC 740-10-25.

Fair Value Measurements

ASC 820 defines fair value as the price that would be received from selling an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. When determining the fair value measurements for assets and liabilities required or permitted to be recorded at fair value, the Company considers the principal or most advantageous market in which it would transact and it considers assumptions that market participants would use when pricing the asset or liability.

ASC 820 establishes a fair value hierarchy that requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. A financial instrument’s categorization within the fair value hierarchy is based upon the lowest level of input that is significant to the fair value measurement. ASC 820 establishes three levels of inputs that may be used to measure fair value:

·

Level 1 – Valuations based on unadjusted quoted prices in active markets for identical assets or liabilities that the Company holds. An active market for the asset or liability is a market in which transactions for the asset or liability occur with sufficient frequency and volume to provide pricing information on an ongoing basis.

·

Level 2 – Valuation based on quoted prices in markets that are not active for which all significant inputs are observable, either directly or indirectly.

·

Level 3 – Valuations based on inputs that are unobservable and significant to the overall fair value measurement.

The Company adopted ASC 820, Fair Value Measurements and Disclosures, on January 1, 2008 for all financial assets and liabilities and non-financial assets and liabilities that are recognized or disclosed at fair value in the consolidated financial statements on a recurring basis (at least annually). ASC 820 defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. The Company has also adopted ASC 820, on January 1, 2009 for non financial assets and non financial liabilities, as these items are not recognized at fair value on a recurring basis. The adoption of ASC 820 for all financial assets and liabilities and non-financial assets and non-financial liabilities did not have any impact on the Company’s consolidated financial statements.

8

Financial instruments include cash, accounts receivable, prepayments and other receivables, short-term borrowings from banks, accounts payable and accrued expenses and other payables. The carrying amounts of cash, accounts receivable, prepayments and other receivables, short-term loans, accounts payable and accrued expenses approximate their fair value due to the short-term maturities of these instruments. See footnote 10 regarding the fair value of the Company’s warrants, which are classified as Level 3 liabilities in the fair value hierarchy.

Recently Issued Accounting Guidance

In May 2011, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2011-04, “Fair Value Measurement (Topic 820)”, which provided clarifications for Topic 820 and also included instances where a particular principle or requirement for measuring fair value or disclosing information about fair value measurement has changed. This Update results in common principles and requirements for measuring fair value and for disclosing information about fair value measurements in accordance with U.S. GAAP and IFRSs, and is effective during interim and annual periods beginning after December 15, 2011 for public entities. Early application by public entities is not permitted, and the adoption of ASU 2011-04 is not expected to have a material impact on the Company’s consolidated financial position and results of operations.

In January 2010, the FASB issued ASU No. 2010-06—Fair Value Measurements and Disclosures (Topic 820): Improving Disclosures about Fair Value Measurements. This Update amends Subtopic 820-10 that require new disclosures about transfers in and out of Levels 1 and 2 and activity in Level 3 fair value measurements. This Update also amends Subtopic 820-10 to clarify certain existing disclosures. The new disclosures and clarifications of existing disclosures are effective for interim and annual reporting periods beginning after December 15, 2009, except for the disclosures about purchases, sales, issuances, and settlements in the roll forward of activity in Level 3 fair value measurements, which are effective for fiscal years beginning after December 15, 2010. The adoption had no impact on the Company’s consolidated financial statements.

In April 2010, the FASB issued an Accounting Standard Update (“ASU”) No.2010-13,” Compensation-Stock Compensation” (Topic 718): Effect of Denominating the Exercise Price of a Share-Based Payment Award in the Currency of the Market in Which the Underlying Equity Security Trades,” which address the classification of a share-based payment award with an exercise price denominated in the currency of a market in which the underlying equity security trades. Topic 718 is amended to clarify that a share-based payment award with an exercise price denominated in the currency of a market in which a substantial portion of the entity’s equity securities trades shall not be considered to contain a market, performance, or service condition. Therefore, such an award is not to be classified as a liability if it otherwise qualifies as equity classification. The amendments in this update should be applied by recording a cumulative-effect adjustment to the opening balance of retained earnings. The cumulative-effect adjustment should be calculated for all awards outstanding as of the beginning of the fiscal year in which the amendments are initially applied, as if the amendments had been applied consistently since the inception of the award. ASU 2010-13 is effective for interim and annual periods beginning on or after December 15, 2010 and do not have a material impact on the Company’s consolidated financial position or results of the operations.

In June 2011, the FASB issued Comprehensive Income (Topic 220) — Presentation of Comprehensive Income (ASU No. 2011-05), which updates the Codification to require the presentation of the components of net income, the components of other comprehensive income (OCI) and total comprehensive income in either a single continuous statement of comprehensive income or in two separate, but consecutive statements of net income and comprehensive income. These updates do not affect the items reported in OCI or the guidance for reclassifying such items to net income. These updates to the Codification are effective for interim and annual periods beginning after December 15, 2011. We do not expect the implementation of this guidance to have a material impact on the Company’s consolidated financial statements.

The Company has considered all new accounting pronouncements and has concluded that there are no new pronouncements that may have a material impact on results of operations, financial condition, or cash flows, based on current information.

9

NOTE 3 – OTHER RECEIVABLES

Other receivables consisted of the following:

June 30,

2011

(Unaudited)

December 31,

2010

Deposits

$

273,768

$

2,202,590

Purchase deposits

885,211

1,276,255

Input value added tax receivables

3,799,121

1,973,079

Loans to suppliers (1)

8,689,625

18,119,405

Rebates receivables

2,204,969

1,725,963

Rent deposits

844,110

1,994,467

Others

604,547

944,638

Total

$

17,301,351

$

28,236,397

(1)

Loans to unrelated vendors are used to secure the merchandise needed during the peak season at the end of the year. The loans were unsecured bearing an interest rate of 6.237% per annum. An amount of approximately $9.3 million was repaid in March 2011. The remaining loans are due on September 30, 2011.

10

NOTE 4 – PROPERTY, PLANT AND EQUIPMENT, NET

Property, plant and equipment consisted of the following:

June 30,

2011

December 31,

(Unaudited)

2010

Buildings

$

6,614,461

$

6,397,575

Shop equipment

21,191,992

13,309,062

Office equipment

4,016,531

3,250,626

Motor vehicles

1,496,611

1,045,720

Car park

19,926

19,480

Leasehold improvements

21,394,438

11,424,560

Construction in progress

1,636,932

2,498,542

Total property, plant and equipment

56,370,891

37,945,565

Less: accumulated depreciation and amortization

(16,587,250)

(13,153,416

)

Total property, plant and equipment, net

$

39,783,641

$

24,792,149

The depreciation expenses for the period ended June 30, 2011 and June 30, 2010 were $3,566,227 and $2,309,342 respectively.

NOTE 5 – ACCURED EXPENSES AND OTHER PAYABLES

Accrued expenses and other payables consisted of the following:

June 30,

2011

(Unaudited)

December 31,

2010

Accrued expenses

$

6,099,599

$

3,652,235

VAT and other PRC tax payable

552,641

946,704

Shop equipment and leasehold improvements payables (1)

14,601,817

3,227,292

Deposit from vendors and employees

2,504,947

2,057,051

Total accrued expenses and other payables

$

23,759,004

$

9,883,282

(1)

Shop equipment and leasehold improvements payables are related to our purchase of shop equipment and payment of leasehold improvements for new stores openings and old stores renovation.

NOTE 6 – EARNINGS PER SHARE

The Company calculates earnings per share in accordance with ASC 260, Earnings Per Share, which requires a dual presentation of basic and diluted earnings per share. Basic earnings per share are computed using the weighted average number of shares outstanding during the fiscal year. Potentially dilutive common shares consist of convertible preferred stock (using the if-converted method) and exercisable warrants and stock options outstanding (using the treasury method).

The following table sets forth the computation of basic and diluted net income per common share:

(Unaudited)

(Unaudited)

Three Months

Ended June 30,

Six Months

Ended June 30,

2011

2010

2011

2010

Net income (loss)

$

(32,867)

$

2,112,369

$

2,554,262

$

13,995,220

Weighted-average shares of common stock outstanding

Basic

29,755,085

29,667,924

29,771,783

29,613,671

Dilutive shares:

Conversion of series A convertible preferred stock

7,264,054

7,359,819

7,267,356

7,412,294

Dilutive effect of stock warrants and options

-

2,831,470

-

3,306,161

Anti-dilutive effect of preferred stock

(7,264,054

)

-

-

-

Diluted

29,755,085

39,859,213

37,039,139

40,332,126

Basic earnings per share

$

(0.001)

$

0.07

$

0.09

$

0.47

Diluted earnings per share

$

(0.001)

$

0.05

$

0.07

$

0.35

The 11,768,860 shares of stock warrants and 2,033,000 options were not included in the computation of diluted net earnings per share as their effects would have been anti-dilutive since the average share price for the three and six months ended June 30, 2011 were lower than the options and warrants exercise price.

11

NOTE 7 – STOCK WARRANTS

Series A and Series B Stock Warrants

As a result of a completed sale of 9,117,647 units for cash proceeds of $15,500,000 on March 28, 2008, the Company issued Series A stock warrants of 5,822,655 and Series B stock warrants of 5,800,911 which can be converted on a one-for-one basis into shares of the Company’s common stock. The stock warrants have a five year life and the Series A warrants are exercisable at an equivalent price of $3.40 per share and the Series B are exercisable at an equivalent price of $4.25 per share. These stock warrants will expire on March 28, 2013 pursuant to the warrant agreements.

The Company used the Black-Scholes option pricing model to determine the fair value of the Series A and B stock warrants on March 28, 2008 (assumptions used – expected life of 5 years, volatility of 89%, risk free interest rate of 2.51%, and expected dividend yield of 0%).

Effective January 1, 2009, the Company adopted the provisions of FASB ASC Topic 815, “Derivatives and Hedging” (“ASC 815”) (previously EITF 07-5, “Determining Whether an Instrument (or an Embedded Feature) is Indexed to an Entity’s Own Stock”). As a result of adopting ASC 815, warrants to purchase 11,623,566 of the Company’s common stock previously treated as equity pursuant to the derivative treatment exemption were no longer afforded equity treatment as there was a down-round protection (full-ratchet down round protection). As a result, the warrants were not considered indexed to the Company’s own stock, and as such, all future changes in the fair value of these warrants were recognized in earnings until such time as the warrants are exercised or expire. The Company reclassified the fair value of these warrants from equity to liability, as if these warrants were treated as a derivative liability. On January 1, 2009, the Company recorded as a cumulative effect adjustment of decreasing additional paid-in capital of $6,020,000 and beginning retained earnings of $2,792,017 and $8,812,017 to warrant liabilities to recognize the fair value of such warrants. The fair value of the warrants was $44,304,034 on December 31, 2009. The Company recognized $35,492,017 loss from the change in fair value of warrants for the year ended December 31, 2009.

The Company amended Series A and Series B stock warrant agreements deleting the down-round protection (full-ratchet down round protection) provision on March 24, 2010. As a result of this amendment, the Company is no longer required to treat Series A and Series B warrants as a liability and was reclassified to equity as of March 24, 2010 (assumption used – expected life of 3 years, volatility of 57%, and risk free interest rate of 1.67%, and expected dividend yield of 0%). Based on the revaluation, the Company recognized $7,801,649 of income related to this transaction and reclassified $36,502,385 to equity for the year ended December 31, 2010.

Warrant C

On January 22, 2010, the Company issued a warrant (“Warrant C”) to a non-related individual in exchange for consulting services relating to operational and managerial experience. Warrant C can be converted into 200,000 shares of the Company’s common stock at an exercise price of $5.00 per share. Warrants C has a five year term and became exercisable 180 days from the date of issuance of Warrant C.

The Company recognized share-based compensation cost based on the grant-date fair value estimated in accordance with ASC 505-50 “equity based payments to non-employees”. The fair value of these stock warrants on the date of grant was estimated using the Black-Scholes method (assumption used – expected life of 2.75 years, volatility of 54%, and risk free interest rate of 1.25%, and expected dividend yield of 0%). The Company recognized $558,180 of compensation expense related to this transaction in the first quarter of 2010.

12

A summary of the Company’s stock warrant activities are as follows:

Shares

Weighted Average Exercise Price

Weighted Average Remaining Contractual Term

Balance – December 31, 2010

11,768,860

$

3.84

2.27

Exercised

-

-

-

Cancelled

-

-

-

Balance – June 30, 2011

11,768,860

$

3.84

1.77

NOTE 8 – SHARED BASED COMPENSATION

Under the 2009 Omnibus Securities and Incentive Plan, on September 14, 2009, the Company entered into stock option agreements with its three independent directors, granting each director options to purchase 20,000 shares of the Company’s common stock at an exercise price of $8.00 per share. The options vest in approximately equal amounts on the three subsequent anniversary dates of the grant and expire on the fifth anniversary of the date of agreement of or the date the option is fully exercised. On January 30, 2010, the Company entered into amendment agreements with its three directors to correct the exercise price to $7.50, which was the fair market value on the date of the grant. The correction of this error was considered immaterial.

Under the 2009 Omnibus Securities and Incentive Plan, on June 26, 2010, the Company granted the its Chief Operating Officer, Alan Stewart and 20 employees options to acquire 2,070,000 shares of the Company's common stock at an exercise price of $4.40 per share. The options vest in approximately equal amounts on the four subsequent anniversary dates of the grant and expire on the eighth anniversary of the date of agreement of or the date the option is fully exercised. On June 17, 2011, Mr. Alan Stewart resigned from his position as Chief Operating Officer of QKL Stores Inc. This has no material impact on the Company’s consolidated financial statements.

Under the 2009 Omnibus Securities and Incentive Plan, on December 2, 2010, the Company granted its Chief Financial Officer, Tsz-Kit Chan options to acquire 100,000 shares of the Company's common stock at an exercise price of $3.42 per share. The options vest in approximately equal amounts on the four subsequent anniversary dates of the grant and expire on the eighth anniversary of the date of agreement of or the date the option is fully exercised.

The Company accounts for its share-based compensation in accordance with ASC 718 and recognizes compensation expense using the fair-value method on a straight-line basis over the requisite service period for share option awards and non-vested share awards granted which vested during the period. The fair value for these awards was estimated using the Black-Scholes option pricing model on the date of grant with the following assumptions:

September 14,

2009

June 26,

2010

December 2,

2010

Expected life (years)

3.5

3.25

3.25

Expected volatility

41.2

%

53

%

44.9

%

Risk-free interest rate

1.69

%

1.49

%

0.96

%

Dividend yield

-

-

-

13

The expected volatilities are based on the historical volatility of the Company’s common stock. The observation is made on a weekly basis. The observation period covered is consistent with the expected life of the options. The expected life of stock options is based on the minimum vesting period required. The risk-free rate is consistent with the expected terms of the stock options and is based on the United States Treasury yield curve in effect at the time of grant.

Stock-based compensation expenses recognized was $216,158 and $432,316 for the three months and the six months ended June 30, 2011. A summary of the Company’s stock options activities under the 2009 Omnibus Securities and Incentive Plan are as follows:

Shares

Weighted Average

Exercise Price

Weighted Average

Remaining Contractual

Term(Years)

Intrinsic Value

Outstanding – December 31, 2010

2,033,000

$

4.44

3.45

$

13,000

Granted

-

-

-

-

Exercised

-

-

-

-

Forfeited

-

-

-

-

-

-

-

-

Outstanding– June 30, 2011

2,033,000

$

4.44

3.02

$

-

Exercisable – June 30, 2011

414,601

$

4.35

3.02

$

-

As of June 30, 2011, there was $2,507,122 of total unrecognized compensation cost related to non-vested share option awards granted. Such cost is expected to be recognized over a weighted-average period of 3-4 years.

NOTE 9 - COMMITMENTS AND CONTINGENCIES

Operating Leases

Certain of our real properties and equipment are operated under lease agreements. Rental expense under operating leases was as follows:

(Unaudited)

(Unaudited)

Three Months Ended

June 30

Six Months Ended

June 30

2011

2010

2011

2010

Rent expense

$

1,932,497

$

785,280

$

4,135,347

$

1,486,017

Less: Sublease income

(302,926

)

(260,232

)

(902,990

)

(508,151

)

Total rent expense, net

$

1,629,571

$

525,048

$

3,232,357

$

977,866

Annual minimum payments under operating leases are as follows:

As of June 30,

Minimum Lease Payment

Sublease

Income

Net Minimum Lease Payment

2012

$

8,817,356

$

517,685

$

8,299,671

2013

9,268,353

41,357

9,226,996

2014

9,180,030

-

9,180,030

2015

9,103,452

-

9,103,452

2016

9,036,304

-

9,036,304

Thereafter

93,963,191

-

93,963,191

Total

$

139,368,686

$

559,042

$

138,809,644

14

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion and analysis of the QKL Stores Inc. and subsidiaries (“we”, “our”, “us”) financial condition and results of operations includes information with respect to our plans and strategies for our business and should be read in conjunction with our interim unaudited condensed consolidated financial statements and related notes (“Interim Financial Statements”) included herein and our consolidated financial statements and related notes, and Management’s Discussion and Analysis of Financial Condition and Results of Operations contained in our Form 10-K for the fiscal year ended December 31, 2010.

Overview

We are a regional supermarket chain that currently operates 32 supermarkets, 15 hypermarkets and 4 department stores in northeastern China and Inner Mongolia. The Company’s supermarkets and hypermarkets sell a broad selection of merchandise including groceries, fresh food and non-food items. A supermarket offers various daily necessities on a self-service basis and averages 2,500 square meters in sales area. A hypermarket is similar to a supermarket but has a larger operating scale, and is typically over 4,500 square meters in sales area. We currently have two distribution centers servicing our supermarkets.

We are the first supermarket chain in northeastern China and Inner Mongolia that is a licensee of the Independent Grocers Alliance, or IGA, a United States-based global grocery network. As a licensee of IGA, the Company is able to engage in group bargaining with suppliers and have access to more than 2,000 private IGA brands, including many that are exclusive IGA brands.

Our expansion strategy emphasizes growth through geographic expansion in northeastern China and Inner Mongolia, where we believe local populations can support profitable supermarket operations, and where we believe competition from large foreign and national supermarket chains, which generally have resources far greater than ours, is limited. Our strategies for profitable operations include buy-side initiatives to reduce supply costs; focusing on merchandise with higher margins, such as foods we prepare ourselves and private label merchandise; and increasing reliance on the benefits of membership in the international trade group IGA.

We completed the initial steps in the execution of our expansion plan in March 2008, when we raised financing through the combination of our reverse merger and private placement and also raised additional financing in our public offering in the fourth quarter of 2009. Under our expansion plan, we opened:

·

ten new stores in 2008 that have in the aggregate approximately 42,000 square meters of space

·

seven new stores in 2009 that have, in the aggregate, approximately 32,000 square meters of space

·

nine new stores in 2010 that have in the aggregate approximately 74,189 square meters of space

·

eleven new stores in the first half of 2011 that have in the aggregate approximately 77,000 square meters of space

We opened 6 new stores in the first quarter and 5 new stores in the second quarter of 2011 that have, in the aggregate, approximately 77,000 square meters of space. We also closed 3 stores due to the expiration of the lease contract in the second quarter. In 2011, we plan to open 12 additional hypermarkets, supermarkets and department stores having, in the aggregate, approximately 80,000 square meters of space. We are also making improvements to our logistics and information systems to support our supermarkets. We expect to finance our expansion plan from funds generated from operations and bank loans. Our long-term target is to open more than 200 stores over the next four to five years, including hypermarkets, supermarkets and department stores.

15

Our Operations in China

Our headquarters and all of our stores are located in the provinces of northeastern China and Inner Mongolia. The economy of this area has grown rapidly over the last four to five years and we believe that the national government is committed to enhancing economic growth in the region. In December 2003, a major economic-development plan for northeastern China, the “Plan for Revitalizing Northeast China,” was announced by an office of the national government’s State Council.

Based on our own research, we believe there are approximately 200 to 300 small and medium-sized cities in northeast China without modern supermarket chains. We believe the number of supermarket customers and the demand for supermarkets in these cities are likely to grow significantly over the next several years as the region continues to experience urbanization.

Our Strategy for Growth and Profitability

Our strategic plan includes the following principal components: expanding by opening stores in new strategic locations, and improving profitability by decreasing the cost through resource purchase, setting up distribution centers and increasing the percentage of our sales attributable to private label merchandise, membership sales and buying card sales.

Expanded Operations

As of June 30, 2011, we operated 32 supermarkets, 15 hypermarkets, 4 department stores, and 2 distribution centers, one in Daqing and one in Harbin. Under our expansion plan, we opened 11 new stores in the first half of 2011 that have, in the aggregate, approximately 77,000 square meters of space, and closed 3 stores due to the expiration of the lease contract in the second quarter. In 2011, we plan to open 12 hypermarkets, supermarkets and department stores having, in the aggregate, approximately 80,000 square meters of retail space. The estimated opening cost of these stores is $15 million. Most of the stores will be opened by us. We are also making improvements to our logistics and information systems to support our supermarkets. We expect to finance our expansion plan from funds generated from operations and bank loans. Based on our previous experience, we believe it takes six to nine months for a new store to achieve profitability.

Private Label Merchandise

Some of the merchandise we sell is made to our specifications by manufacturers using the QKL brand name. We refer to such merchandise as “private label” merchandise. With private label merchandise, we entrust the manufacturer to make the product and to select the name and design. Under our agreements with the private label manufacturer, the private label manufacturers cannot sell the product to any other party. Sales of private label merchandise accounted for approximately 5.5% and 5% of our total revenues for the six months ended June 30, 2011 and 2010, respectively. In June 2008, we established a specialized department for designing and purchasing private label merchandise, in which 7 full-time employees currently work. Our goal is to increase private label sales to 20% of our total revenues.

Principal Factors Affecting Our Results

The following factors have had, and we expect they will continue to have, a significant effect on our business, financial condition and results of operations.

Seasonality – Our business is subject to seasonality, with increased sales in the first quarter and fourth quarter, due to increases in shopping and consumer activity as a result of the holidays such as New Year (January 1), Chinese Lunar New Year (January or February), the Dragon Festival (February 2), Women’s Day (March 8), the Back to School Day (March 1), National Day (October 1), Mid-Autumn Festival (September or October) and Christmas (December 25).

16

Timing of New Store Openings – Growth through new store openings is a fundamental part of our strategy. Our new stores typically operate at a loss for approximately three months due to start-up inventory and other costs, promotional discounts and other marketing costs and strategies associated with new store openings, rental expenses and costs related to hiring and training new employees. Our operating results, and in particular our gross margin, have and will continue to vary based in part on the pace of our new store openings.

Locations for New Store – Good commercial space that meets our standards, in locations that meet our needs, may be scarce in some of the cities we wish to enter. One option for entering certain target markets within our intended timeframe may be to begin operations in a location that is not optimal and wait for an opportunity to move to a better location. Alternatively, we may seek to enter into a target market through acquisitions. As such, the timing and costs associated with entry into new markets can be difficult to predict. Identifying and pursuing opportunities will be a resource-intensive challenge, and if we do not perform or if actual costs of entering new markets exceed our expectations, our total revenues, cash flows, and liquidity could suffer.

Logistics of Geographic Expansion – Opening additional stores in cities further from our headquarters in Daqing will mean that the transportation of our supplies and personnel among our stores will become more difficult and subject to disruption. To alleviate this, we have opened a new distribution center in Harbin in the second quarter of 2010. We started using our regional purchasing systems in 2008. All fresh food is ordered by individual stores based on their needs from local vendors designated by our headquarters or regional purchasing department and is delivered directly by the local vendors to individual stores. A portion of our non-perishable food and non-food items are distributed from our distribution center to our different stores, and the remaining portion is purchased by our regional purchasing department or headquarters and delivered directly to individual stores. Long-distance transportation for both food and non-food items from our distribution center to our stores can be challenging in the winter as the roads can be covered with snow. As we expand in territories further from our existing or planned distribution facilities, the costs of delivering food and merchandise may become less predictable and more volatile.

Human Resources – In our experience, it takes approximately three months to train new employees to operate a new store. Training and supervision is organized by experienced teachers in our training school. The management team for a new store is hired first and is trained in our training school, where they learn our culture and operations. Employees are hired afterwards, and are trained by both our teachers and the management team. In addition, the management team and the employees are sent to existing stores to get practical training from the employees and management team members in those stores. Eventually, local employees must learn to perform the training and supervisory roles themselves. If we do not perform well in response to these challenges, our operating costs will rise and our margins will fall.

Shortages of Trained Staff in Our New Locations – Opening stores in locations with little or no competition from other large supermarkets is a major part of our strategy. However, there are disadvantages to this approach, which relate to human resources. Where competitors operate supermarkets nearby, their trained staff is a potential source for our own human resources needs, especially if we offer a superior compensation package. Cities that have no large supermarkets also have no sources of trained employees. Although we believe we have a good training school, from time to time we have to send experienced management team members from our headquarters or other stores to new stores to provide assistance. This increases our cost of operating and decreases our gross margin.

17

Critical Accounting Estimates

As discussed in Part II, Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, of our Annual Report on Form 10-K for the fiscal year ended December 31, 2010, we consider our estimates on revenue recognition, vendor allowances, and inventory valuation to be the most critical in understanding the judgments that are involved in preparing our consolidated financial statements. There have been no significant changes to these estimates in the six months ended June 30, 2011.

Recently Issued Accounting Guidance

See Note 2 to condensed consolidated financial statements included in Item 1, Financial Information, of this Quarterly Report on Form 10-Q.

Results of Operations

The following table sets forth selected items from our condensed consolidated statements of income by dollar and as a percentage of our net sales for the periods indicated:

(Unaudited)

Three Months Ended

June 30, 2011

(Unaudited)

Three Months Ended

June 30, 2010

Amount

% of

Net Sales

Amount

% of

Net Sales

Net sales

$

83,453,372

100.0

%

$

66,099,594

100.0

%

Cost of sales

68,828,405

82.5

54,504,918

82.5

Gross profit

14,624,967

17.5

11,594,676

17.5

Selling expenses

12,749,493

15.3

7,117,955

10.8

General and administrative expenses

1,946,466

2.3

1,731,613

2.6

Operating income (loss)

(70,992

)

(0.1

)

2,745,108

4.1

Changes in fair value of warrants

-

-

-

-

Interest income

163,762

0.2

195,810

0.3

Interest expense

-

0.0

(8,201

)

0.0

Income before income taxes

92,770

0.1

2,932,717

4.4

Income taxes

125,637

0.2

820,348

1.2

Net income (loss)

$

(32,867

)

0.0

%

$

2,112,369

3.2

%

Net Sales – Net sales increased by $ 17.4 million, or 26.3%, to $83.5 million for the three months ended June 30, 2011 from $66.1 million for the three months ended June 30, 2010. The change in net sales was primarily attributable to the following:

§

Same store sales represents sales from stores that were opened for at least one year before the beginning of the comparison period, or by April 1, 2010. Same store (33 stores) sales generated approximately $67.2 million sales in the second quarter of 2011, an increase of $4.7 million, or 7.6% compared with $62.5 million net sales in the second quarter of 2010.

18

§

New store sales increased, reflecting the net opening of 18 new stores since April 1, 2010. These 18 stores generated approximately $14.1 million sales in the second quarter of 2011.

§

The number of stores including supermarkets/hypermarkets and department stores at June 30, 2011 was 51 versus 37 at June 30, 2010.

Cost of Sales – Our cost of sales for the three months ended June 30, 2011 was approximately $68.8 million, representing an increase of $14.3 million, or 26.3%, from approximately $54.5 million for the same period in 2010. The increase was due to the increase in volume of sales. Our cost of sales primarily consists of the cost for our merchandise; it also includes costs related to packaging and shipping and the distribution center costs.

Gross Profit – Gross profit, or total revenue minus cost of sales, increased by $3.0 million, or 26.1%, to $14.6 million, or 17.5% of net sales, in the second quarter of 2011 from $11.6 million, or 17.5% of net sales, in the second quarter of 2010. The change in gross profit was primarily attributable to net sales increased by $17.4 million in the second quarter of 2011 compared to the second quarter of 2010.

Selling Expenses –Selling expenses increased by $5.6 million, or 79.1%, to $12.7 million, or 15.3% of net sales, in the second quarter of 2011 from $7.1 million, or 10.8% of net sales, in the second quarter of 2010. The change in selling expense was mainly due to increase in labor costs due to increase in the number of store employees and pay rise, depreciation, rent expense, and utilities and other operating costs in the three months ended June 30, 2011 compared to same period in 2010 primarily due to support of an increase in store count. In specific, labor costs increased by $1.8 million or 72.7%, to $4.3 million in the second quarter of 2011 from $2.5 million in the second quarter of 2010. Depreciation increased by $1.2 million, or 132.3%, to $2.1 million in the second quarter of 2011 from $0.9 million in the second quarter of 2010. Rent expenses increased by $0.9 million, or 258.1%, to $1.3 million in the second quarter of 2011 from $0.4 million in the second quarter of 2010. Utilities increased by $0.8 million, or 73.2%, to $1.9 million in the second quarter of 2011 from $1.1 million in the second quarter of 2010. Preliminary expenses related to new stores increased by $0.9 million to $1.3million in the second quarter of 2011 from $0.4 million in the second quarter of 2010.

General and Administrative Expense –General and administrative expenses increased by $0.2 million, or 12.4%, to $1.9 million, or 2.3% of net sales, in the second quarter of 2011 from $1.7 million, or 2.6% of net sales, in the second quarter of 2010. The increase was mainly due to higher labour cost.

Income Taxes –The provision for income taxes was $0.1 million for second quarter of 2011 compared with $0.8 million for second quarter of 2010.This decrease was primarily due to lower taxable income. Our effective tax rate was 135.4% for second quarter of 2011, compared with 28.0% for second quarter of 2010. This increase was primarily due to higher taxable income resulting from higher non-deductible expenses relating to overseas expenditure and stock based compensation expenses in the three months ended June 30, 2011 compared to the same period during 2010.

19

Net Income – For the three months ended June 30, 2011, our net loss was approximately $32,867, compared to net income of $2.1 million for the three months ended June 30, 2010. This decrease was due to higher selling expenses related to new stores opening and higher staff costs in the second quarter of 2011. The opening costs of new stores are expected to decrease in the next quarter due to our slower expansion plan in the second half of 2011.

Six months ended June 30, 2011 compared with six months ended June 30, 2010

The following table sets forth selected items from our condensed consolidated statements of income by dollar and as a percentage of our net sales for the periods indicated:

(Unaudited)

Six Months Ended

June 30, 2011

(Unaudited)

Six Months Ended

June 30, 2010

Amount

% of

Net Sales

Amount

% of

Net Sales

Net sales

$

184,764,468

100.0

%

$

147,705,707

100.0

%

Cost of sales

152,044,021

82.3

121,584,917

82.3

Gross profit

32,720,447

17.7

26,120,790

17.7

Selling expenses

25,286,696

13.7

13,983,993

9.5

General and administrative expenses

4,150,083

2.2

3,898,871

2.6

Operating income

3,283,668

1.8

8,237,926

5.6

Changes in fair value of warrants

-

-

7,801,649

5.3

Interest income

453,385

0.3

344,928

0.2

Interest expense

(31,100

)

0.0

(10,381

)

0.0

Income before income taxes

3,705,953

2.0

16,374,122

11.1

Income taxes

1,151,691

0.6

2,378,902

1.6

Net income

$

2,554,262

1.4

%

$

13,995,220

9.5

%

Net Sales – Net sales increased by $37.1 million, or 25.1%, to $184.8 million for the six months ended June 30, 2011 from $147.7 million for the six months ended June 30, 2010. The change in net sales was primarily attributable to the following:

§

Same store sales represents sales from stores that were opened for at least one year before the beginning of the comparison period, or by January 1, 2010. Same store (31 stores) sales generated approximately $144.2 million sales in the first half of 2011, an increase of $11.0 million, or 8.3% compared with $133.2 million net sales in the first half of 2010.

§

New store sales increased, reflecting the net opening of 20 new stores since January 1, 2010. These 20 stores generated approximately $34.6 million sales in the first half of 2011 compared to $3.3 million in the first half of 2010.

§

The number of stores including supermarket/hypermarket and department stores at June 30, 2011 was 51 versus 37 at June 30, 2010.

Cost of Sales – Our cost of sales for the six months ended June 30, 2011 was approximately $152.0 million, representing an increase of $30.4 million, or 25.1%, from approximately $121.6 million for the same period in 2010. The increase was due to the increase in volume of sales, although the cost of sales as a percentage of net sales remained the same at 82.3% for each period. Our cost of sales primarily consists of the cost for our merchandise; it also includes costs related to packaging and shipping and the distribution center costs.

20

Gross Profit – Gross profit, or total revenue minus cost of sales, increased by $6.6 million, or 25.3%, to $32.7 million, or 17.7% of net sales, in the first half of 2011 from $26.1 million, or 17.7% of net sales, in the first half of 2010. The change in gross profit was primarily attributable to net sales that increased by $37.1 million in the first half of 2011 compared to the first half of 2010.

Selling Expenses – Selling expenses increased by $11.3 million, or 80.8%, to $25.3 million, or 13.7% of net sales, in the first half of 2011 from $14.0 million or 9.5% of net sales in the first half of 2010. The change in selling expense was mainly due to increase in labor costs, depreciation, rent expense, and utilities and other operating costs in the six months ended June 30, 2011 compared to same period in 2010 primarily due to support of an increase in store count. In specific, labor costs increased by $3.5 million or 75.9%, to $8.2 million in the first half of 2011 from $4.7 million in the first half of 2010. Depreciation increased by $1.4 million, or 84.7%, to $3.2 million in the first half of 2011 from $1.8 million in the first half of 2010. Rent expenses increased by $1.3 million, or 149.3%, to $2.1 million in the first half of 2011 from $0.8 million in the first half of 2010. Utilities increased by $1.4 million, or 67.1%, to $3.4 million in the first half of 2011 from $2.0 million in the first half of 2010. Preliminary expenses related to new stores increased by $2.8 million to $3.5 million in the second quarter of 2011 from $0.7 million in the second quarter of 2010.

General and Administrative Expense – General and administrative expenses increased by $0.3 million, or 6.4%, to $4.2 million, or 2.3% of net sales, in the first half of 2011 from $3.9 million, or 2.6% of net sales, in the first half of 2010. The increase was mainly due to higher labour cost.

Changes in fair value of warrants –In the first quarter of 2010 we recognized a non-cash income of $7.8 million unrelated to the company’s operations, which resulted from the change in fair value of warrants issued to investors in conjunction with the Company’s issuance of warrants in March 2008 pursuant to provisions of FAB ASC Topic 815, “Derivative and Hedging” (“ASC 815”). The accounting treatment of the warrants resulted from a provision providing anti-dilution protection to the warrant holders. The warrant holders have permanently waived the “down-round” protection from the warrants as of March 24, 2010. Therefore, the non-cash charges affecting net income will not be applied after that day, for details, please see Note 6.

Income Taxes – The provision for income taxes was $1.2 million for first half of 2011, compared with $2.4 million for first half of 2010. Excluding the effect of changes in fair value of warrants, our effective tax rate was 31.1% for first half of 2011, compared with 27.8% for first half of 2010. This increase was primarily due to higher taxable income resulting from higher non-deductible expenses relating to overseas expenditure and stock based compensation expenses in the six months ended June 30, 2011 compared to same period during 2010.

Net Income – For the six months ended June 30, 2011, net income was approximately $2.6 million, compared with $14.0 million for the six months ended June 30, 2010. Excluding changes in the fair value of warrants, adjusted net income for the first half of 2010 decreased 58.2% to $2.6 million, or $0.07 per diluted share, from $6.2 million, or $0.15 per diluted share, in the prior year period. This decrease was due to higher selling expenses related to new stores opening and higher staff costs in the second quarter of 2011. The number of shares used in the computation of diluted EPS decreased 8.2% to 37.0 million shares from 40.3 million shares for the same period during 2010.

Liquidity and Capital Resources

Our principal liquidity requirements are for working capital and capital expenditures. We fund our liquidity requirements primarily through cash on hand, cash flow from operations and borrowings from our revolving credit facility. We believe our cash on hand, future funds from operations and borrowings from our revolving credit facility will be sufficient to fund our cash requirements for at least the next twelve months. There is no assurance, however, that we will be able to generate sufficient cash flow or that we will be able to maintain our ability to borrow under our revolving credit facility.

21

At June 30, 2011, we had $36.0 million of cash compared to $59.4 million at June 30, 2010. The following table sets forth a summary of our cash flows for the periods indicated:

(Unaudited)

Six Months Ended

June 30,

2011

2010

Net cash provided by operating activities

$

25,973,275

$

5,286,251

Net cash provided by (used in) investing activities

(7,733,129

)

8,239,350

Net cash provided by financing activities

-

-

Effect of foreign currency translation

332,622

(13,352

)

Net increase in cash

$

18,572,768

$

13,512,249

Seasonality

The seasonality of our business historically provides greater cash flow from operations during the holiday and winter selling season, with the fourth quarter net sales traditionally generating the strongest profits of each year. Typically, we use operating cash flow and borrowings under our revolving credit facility to fund inventory increases in anticipation of the holidays and our inventory levels are at their highest in the months leading up to Chinese Spring Festival. As holiday sales significantly reduce inventory levels, this reduction, combined with net income, historically provides us with strong cash flow from operations at the end of each year.

Operating Activities –Net cash provided by operating activities for the six month ended June 30, 2011 and 2010 was $26.0 million and $5.3 million, respectively. The increase in cash provided by operating activities for the six month ended June 30, 2011 compared to the same period in 2010 primarily reflects net cash inflow caused by the increase in accrued expenses, decrease of inventories and decrease of other receivables. The increase in accrued expenses was in line with our increase in operating expenses due to inflation and new store openings. The decrease of inventories was caused by reducing the inventory on hand after the peak Chinese New Year season. The decrease of other receivables is largely attributable to the repayment of money from vendors.

Investing Activities – Net cash used in investing activities for the first half of 2011 was $7.7 million and net cash provided by investing activities or the first half of 2010 was $8.2 million. Capital expenditures represented substantially all of the net cash used in investing activities for each period. Capital expenditures were higher in the first half of 2011 due to substantially more new store openings. Our capital spending is primarily for new store openings and store-related remodeling.

Financing Activities – Net cash used for financing activities for the first half of 2011 and 2010 was nil, respectively.

Loan Facility – As of June 30, 2011, we did not have any outstanding revolving line of credit.

On July 6, 2011, QKL Chain entered into a working capital agreement with Longjiang Commercial Bank. Under this agreement, QKL Chain has a credit line up to approximately $7.7 million (RMB50.0 million). The term of any loan under the agreement is one year after the date the loan is issued, with the annual interest rate of 6.941%. The loan under this financing agreement is secured by buildings with appraisal value of approximately $11.9 million (RMB 77.0 million).

On July 6, 2011, Qinglongxin Commerce also entered into a working capital agreement with Longjiang Commercial Bank. Under this agreement, Qinglongxin Commerce has a credit line up to approximately $7.7 million (RMB50.0 million). The term of any loan under the agreement is one year after the date the loan is issued, with the annual interest rate of 6.941%. The loan under this financing agreement is guaranteed by QKL Chain.

Future Capital Requirements – We had cash on hand of $36.0 million as of June 30, 2011. We expect capital expenditures for the remainder of 2011 primarily to fund the opening of new stores, store-related remodeling and relocation. We anticipate opening a total of 12 new stores with an aggregate of 80,000 square meters of space in 2011. The estimated opening cost of these stores is $15 million.

We believe we will be able to fund our cash requirements, for at least the next 12 months from cash on hand, operating cash flows and borrowings from our revolving credit facility. However, our ability to satisfy our cash requirements depends upon our future performance, which in turn is subject to general economic conditions and regional risks, and to financial, business and other factors affecting our operations, including factors beyond our control. There is no assurance that we will be able to generate sufficient cash flow or that we will be able to maintain our ability to borrow under our credit facility.

If we are unable to generate sufficient cash flow from operations to meet our obligations and commitments, we will be required to refinance or restructure our indebtedness or raise additional debt or equity capital. Additionally, we may be required to sell material assets or operations, suspend or further reduce dividend payments or delay or forego expansion opportunities. We might not be able to implement successful alternative strategies on satisfactory terms, if at all.

Off-Balance Sheet Arrangements and Contractual Obligations – Our material off-balance sheet arrangements are operating lease obligations. We excluded these items from the balance sheet in accordance with generally accepted accounting principles in the United States of America (“GAAP”). Operating lease commitments consist principally of leases for our retail store facilities and distribution center. These leases frequently include options which permit us to extend the terms beyond the initial fixed lease term. With respect to most of those leases, we intend to renegotiate those leases as they expire.

In the ordinary course of business, we enter into arrangements with vendors to purchase merchandise in advance of expected delivery. Because most of these purchase orders do not contain any termination payments or other penalties if cancelled, they are not included as outstanding contractual obligations.

22

Item 3. Quantitative and Qualitative Disclosures about Market Risk

Pursuant to Item 305(e) of Regulation S-K (§ 229.305(e)), the Company is not required to provide the information required by this Item as it is a “smaller reporting company,” as defined by Rule 229.10(f)(1).

Item 4T. Controls and Procedures

Evaluation of Disclosure Controls and Procedures –We conducted an evaluation, under the supervision andwith the participation of our Chief Executive Officer (“CEO”) and ChiefFinancial Officer (“CFO”), of the effectiveness of the design and operation ofour disclosure controls and procedures (as such term is defined in Rules13a15(e) and 15d15(e) under the Securities Exchange Act of 1934, as amended(the “Exchange Act”) as of the end of the period covered by this report. Based on such evaluation, our CEO and CFO have concluded that, as of the end of such period, our disclosure controls and procedures are not effective, at a reasonable assurance level, in recording, processing, summarizing and reporting, on a timely basis, information required to be disclosed by us in the reports that we file or submit under the Exchange Act and are not effective in ensuring that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is accumulated and communicated to our management, including our CEO and CFO, as appropriate to allow timely decisions regarding required disclosure.

In particular, we did not maintain effective controls over the financial reporting process due to an insufficient complement of personnel with a level of accounting knowledge, experience and training in the application of U.S. GAAP commensurate with the Company’s financial requirements. Also, there is an insufficient quantity of dedicated resources and experienced personnel involved in the general controls over information technology on our new ERP system implementation.

The conclusion that our internal control over financial reporting was not effective was based on material weaknesses we identified in relation to our financial closing process

Remediation Measures for Material Weaknesses – We have begun to take steps to remediate the material weaknesses described above in “Evaluation of Disclosure Controls and Procedures” and plan to implement the new measures described below in our ongoing efforts to address the internal control deficiencies described above. We plan to further develop policies and procedures governing the hiring and training of personnel to better ensure sufficient personnel with the requisite knowledge, experience and training in the application of generally accepted accounting principles commensurate with our financial reporting and U.S. GAAP requirements. We plan to utilize qualified internal control consultants and supervisors to ensure that our staff has adequate professional knowledge and to monitor the need for additional or better qualified staff. In addition, we plan to utilize appropriate training programs on accounting principles and procedures to better ensure the adequacy of our accounting and finance personnel. We plan to continue to develop our corporate culture toward emphasizing the importance of internal controls and to ensure that all personnel involved in maintaining proper internal controls recognize the importance of strictly adhering to accounting principles accepted in the United States of America. We plan to continue to provide additional training to the Company’s internal audit staff on appropriate controls and procedures necessary to document and evaluate our internal control procedures.

Changes in Internal Control over Financial Reporting – During the fiscal quarter ended June 30, 2011, no changes occurred with respect to our internal control over financial reporting that materially affected, or are reasonably likely to materially affect, internal control over financial reporting.

23

PART II. OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

None.

ITEM 1A. RISK FACTORS

As a smaller reporting company, the Company is not required to make disclosures under this Item 1A.

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

Site Links

Based on public records. Inadvertent errors are possible. Getfilings.com does not guarantee the accuracy or timeliness of any information on this site. Use at your own risk.
This website is not associated with the SEC.